Sunday, September 24, 2006

The problem with Amaranth is ... gambling

I described the difference between traders and gamblers back in July. Jeff Matthews describes Long Term Capital and Amaranth in a similar way:

The most memorable part of Roger Lowenstein’s excellent book on the Long Term Capital Management debacle (quoted above) was when LTCC’s founder, John Meriwether, called a retired, street-wise, market-savvy ex-Bear Stearns confidant for advice.

When he heard LTCC was down 50%, the old-timer didn't mince words. He told Meriwether: “You’re finished.”

What the old pro was telling the computer-driven “Genius” of the book title was that when the market smells blood in the water, it goes after whatever is bleeding and doesn’t let go.

Now, this week’s blow-up of Amaranth, a Greenwich Connecticut-based hedge fund which appears to have fallen victim to some wild and crazy natural gas trading, does not, as far as anybody knows, rival LTCC’s when it comes to potentially bringing down the system.

After all, LTCC had margined their positions into a nominal exposure close to a trillion dollars, compared to the multiple billions involved at Amaranth.

Nevertheless, the two situations are not entirely unrelated. As happened with LTCC, when word of a problem at a hedge fund hit the natural gas markets last week, those markets appear to have started going precisely the wrong way for the fund most exposed to those moves—Amaranth.

I have no idea how the situation will unwind, and I certainly hope there isn’t the kind of second and third-derivative damage in other markets of the type that caused LTCC’s demise to force an emergency session of the Federal Reserve. Those were very dark days.

But the lesson is obvious: for all the confidant talk about how derivatives off-load risk and therefore create a safer financial world, there is something to the notion that what we are building up here is the potential for a liquidity crisis that brings the system down.

If you can lose half of your account worth in a single contract, then you are a gambler, like this guy. An old colleague of mine was trading Nikkei right next to him, and everyone in the pit knew that he had a huge position, and refused to let him out without him paying his right arm on top of fair value.

Same thing could happen to you, if you are sitting on a huge position and liquidity all of a sudden dries up. My advice is to keep your exposure on any one contract (or series, e.g. long moneyline, short spread) to 5% or less of your account or the open interest, whichever is lesser. Live to trade another day. And another. Gambling = Death (unless you have more money than the house).